Mais où est le rendement ?

Key points

Eurozone equity dividend yields of 3.1% make the asset class compelling to explore for investors seeking income in the prevailing ultra-low yield environment.

Top-down metrics show the dividend pay-out ratio is close to current cycle norms with a healthy free cash flow buffer. While corporate leverage has edged up recently, interest coverage remains comfortable.

Given the high cyclicality of euro area dividends, macro-economic shocks remain a risk. Their sensitivity during times of crisis is double that of overall developed market equities and have failed to regain their 2008 dividend-per-share high-water mark.

We explore three dividend investing approaches: High dividend yield, high dividend growth and dividend policy discipline. These have outperformed regional benchmarks, with the latter two delivering the best mix of income and capital gains.

Our portfolio simulations suggest that dividend investing could potentially provide a hybrid approach between pure-income and pure-growth for investors in need of a cash flow stream that helps shield them from inflation.

Dividend yields close to five-decade average

Equities are currently a rare liquid asset class in the euro area with yields on aggregate close to 3.1%. Current levels are close to their five-decade average, last observed in 2016 (Exhibit 1). This is in stark contrast to euro-denominated bonds, where over 60% of the investment-grade universe – both government and corporate – trades at sub-zero yields, and near zero overall. The obvious concern here is the reason for this distortion. In the favourable case (for equity) the low bond yields are mostly driven by pre-emptive monetary policy easing and have not spilled over into equity valuations; in the less favourable case, investors simply don’t buy that current dividend pay-outs are sustainable (or fear large capital losses) due to the weak growth prospects in the region, business model disruption and not to mention a variety of macro risks, and pile into fixed income assets.

Yield gaps relative to euro-denominated fixed income make a compelling case to explore for investors hunting for income from traditional assets. Relative to government bonds, the gap is close to multi-decade highs at 3%. Similarly, the yield gap is around 2.5% relative to investment grade credit (IG) and almost at par with high yield credit (HY)[1]. Relative to historical levels, the picture remains the same excluding the financial sector[2], although yield gaps do narrow to 2.7% relative to government bonds, 2.2% versus investment grade and -1% against high yield credit (Exhibit 2).

Breaking down index aggregates, the juicy dividend yields are far from evenly distributed across sectors (Exhibit 3). Financials alone contribute almost 30% of the aggregate yield, given their high yield (4.6%) and heavy weight. The sector has also seen the largest decline in dividend per share (DPS) since the global financial crisis (GFC). Aggregate yields excluding financials offer around 2.8% – still attractive and at the higher end of the historical range excluding crisis episodes. Given the divergences in fundamentals, even within sectors, a bottom-up approach to assess pay-out sustainability should be favoured.

The feedback loop between pay-out and growth

Corporate finance 101 tells us that the sustainable growth rate of a business is a function of its reinvestment rate and profitability. Essentially, the flipside of more dividends (less reinvestment) without rising profitability is lower growth. This is visible in broad performance trends in the current cycle, with countries and sectors with higher pay-out ratios demonstrating lower earnings growth.

Drivers of profitability – in terms of return on equity – can be broken down into asset turnover (revenue to assets), profit margins and lastly – usually having negative connotations – financial leverage. Goes without saying, pay-outs fuelled by excessive debt would raise caution. Post-financial crisis, profit margins appear to be the swing factor for euro area corporates, which have overall refrained from gearing up balance sheets and maintained asset turnover (Exhibit 4).

Dividends therefore have their positives and their negatives, depending on the drivers and scale of pay-outs. A stable dividend policy is often considered an acid test for good corporate governance. A useful framework to assess dividend policy is weighing cash generation (surplus or deficit) against potential projects. For instance, a cash surplus and attractive projects would suggest maximum dividend flexibility. On the other hand, a cash deficit with poor projects would be a red flag[3].

The wary fundamentals of euro area equities on aggregate do warrant some healthy scepticism about the sustainability of dividend pay-outs today, much like one would think about default risk for a high-yielding bond. Gauging top-down metrics for euro area equities gives out mixed signals, but on balance it doesn’t ring alarm bells. The dividend pay-out ratio (as a share of earnings) close to 55% is above current cycle norms, but the free cash flow buffer remains healthy. Pay-out ratios have been structurally increasing, possibly reflecting the lack of lucrative capex opportunities and depressed earnings. Financial leverage has started to edge up recently, but interest coverage ratios remain comfortable, driven by record low interest rates (Exhibit 5).

A discussion on shareholder pay-out policy would be incomplete without considering the implications of share repurchases, which have become an increasingly important force in equity markets. In this bull market, share repurchases have been the largest driver of global equity demand. Although the buyback phenomenon has been largely a topic for corporate America, it has been on the rise globally. Please refer to our previous note for a more detailed discussion on buybacks[4].

Dividend investing and the macro cycle

Often overshadowed by price volatility, dividends do make a sizable contribution to total returns. Breaking down total returns from the early 1970s to the end of 2018, Eurozone equities have delivered 10.1% nominal annualised total returns, with earnings per share (EPS) growth making up 6.3%, dividend yield 3.4% and a mere 0.2% coming from valuations. DPS growth has been around 6.4% over the same period, in line with price returns and EPS growth. The volatility of prices, EPS and DPS have been 19%, 16% and 12% respectively, over the same time frame. This illustrates how prices, EPS and DPS swing by different magnitudes – the difference being driven by valuation multiple/equity risk premia fluctuations, based on the prevailing market outlook – but tend to move in sync in the long-term (Exhibit 6).

Thus, economic shocks do remain a significant risk and would still loom over a well-selected diversified portfolio of dividend payers. Dividends per share in the euro area, like earnings, have reflected a large cyclical element more so compared to global indices. The typical sensitivity of dividends to earnings during times of crisis has been twice that of overall developed markets (circa 0.8x versus 0.4x). Yields have been more stable, with the spike during the crisis simply reflecting prices falling more than dividends. The average DPS drawdown during economic shocks has been around 20% since the early ‘70s. Severe recessions, like in the 1980s or the GFC have seen DPS cut to the tune of 30%-40%. Euro area equities have still failed to regain their high-water mark for EPS and DPS from the heavy drawdown that began in 2009 (Exhibit 7).

Historically there has been little (measurable) relation between the level of dividend yields and bond yields across markets. The current ultra-low interest rate and low growth regime has triggered a search for growth stocks (and quality stocks) within equities rather than yield – reflected in the decade-long outperformance of equity market growth factors compared to value factors. As illustrated in the next section, dividend per share growth has been amongst the best fundamental factors to explain long term equity returns.

Growth, discipline, yield – all or none?

Since dividend pay-outs are largely a capital allocation mechanism (as discussed earlier), in the absence of any tax arbitrage[5] between dividends and capital gains, should one be indifferent and just maximise total returns? This thought was put forward by Miller and Modigliani as the “dividend irrelevance theory”[6]. For cash flow needs, investors can appropriately sell down their holdings. Given the lack of “natural yield”, the arguable drawbacks to this tactic include trading costs and market timing risks.

In the current setup, dividend investing does offer a potential solution to stable income seekers. The trade-off is more volatility, drawdown risk and non-contractual returns for higher, possibly growing, income and additional long-term capital gains. Dividend investing offers a hybrid between all-income and all-growth which could be ideal for investors in need of an income stream which could protect from inflation.

We explore three common dividend investing approaches: High dividend yield, high dividend growth and dividend policy discipline (or stable dividend), by simulating the returns of representative stock baskets. For high dividend yield, the basket comprises the top quartile of dividend yielders in the MSCI euro area universe. Similarly, the high dividend growth basket is made up of the top quartile of companies with the fastest DPS growth rate. The discipline dividend policy basket includes companies that haven’t cut their annual DPS in the last decade at any point during the time frame under consideration.

Historically, DPS growth stocks with circa 11% total returns and disciplined dividend policy (around 10% total returns) stand out, considerably outperforming regional benchmark indices (circa 6%). The nominal dividend yield of around 3% offered on both has mimicked that of benchmarks with significant extra capital appreciation over the sample time frame. On the other hand, the high dividend yield basket offers a considerable yield pickup (up to around 5%) but its total returns only slightly beat benchmarks with similar volatility of about 19% (Exhibit 8; please refer to footnote for more details on methodology).

The drawback of assessing total returns is the underlying assumption that dividends are reinvested back into the asset or portfolio which then harnesses the power of compounding. In practice, income seekers are likely to use payments to fund cashflow liabilities. Simulating historical performance after funding inflation-indexed hypothetical expenses illustrates that the dividend growth and disciplined dividend policy approach still deliver superior results. It also shows they offer the best combination of income and capital appreciation (Exhibit 9; please refer to footnote for details on methodology).

The non-contractual nature of dividend payments could lead to potential cashflow mismatches, given the uncertainty around the timing of payments. Historical patterns show predictable annual seasonality in dividend payments for these diversified equity portfolios. This suggests that any short-term cashflow mismatches can be overcome by managing a small cash buffer - as considered in the portfolio simulations illustrated in Exhibit 9 - or alternatively using some sort of short-term credit facility.

As discussed earlier, these strategies still bear the risk of dividend cuts during periods of macro-economic weakness. The DPS drawdown patterns of the high dividend yield basket have been like those of aggregate euro area equities (slightly higher in magnitude) and the group has also not regained its pre-crisis DPS high-water mark. This shows that high yielding stocks should be scrutinised for pay-out sustainability. Meanwhile the pay-out level from the divided growth basket has been more resilient. Although the drawdown following the financial crisis was large, DPS levels have been recouped and are now slightly over 70% higher than their pre-crisis peak. The disciplined policy group has demonstrated high resilience with consistently lower DPS drawdowns which have been recovered quickly (Exhibit 10).

We attempt to address the question that might spring to any asset allocator’s mind - how do these dividend strategies size up against fixed income instruments in terms of risk and return?

Over the sample time frame, euro investment-grade credit has delivered the best risk return balance (measured using Sortino ratios[9]) due to the low risk profile of 3.7% volatility and 1.5% downside deviation. However, as one would expect, the annualised total return (circa 4%) delivered by the asset class, has considerably underperformed the dividend strategies and European equity markets in general.

A more like-for-like comparison would be high-yield credit, which has demonstrated a risk/return profile in the same ball park. Euro high-yield credit’s risk/return dynamics have been largely in line with our high dividend yield basket, with Sortino ratios of 0.46 and 0.42 respectively. The disciplined dividend policy basket is next in line at 0.66, followed by the dividend growth group (at 0.78) which has offered the best risk adjusted return (Exhibit 11). Aggregate euro area equities have under-delivered, lagging in terms of total returns and exhibiting higher volatility – demonstrating the merits of active investment management within the asset class.

While high yield credit’s volatility of around 13% is considerably lower than the dividend strategies, its downside deviation – the volatility of negative returns (to differentiate between good and bad volatility from the perspective of a long only investor) is broadly in line. The differences between overall volatility and downside deviation gradually decrease as we move down the risk spectrum from the simulated dividend strategies to the high yield credit index (Exhibit 12). That said, with credit being higher in the corporate capital stack, during risk off episodes drawdowns do tend to be considerably more severe for the dividend strategies compared to aggregate high yield credit. On average, the total return drawdowns for the dividend growth and disciplined dividend baskets have been around 2.5 times the high yield index during episodes of financial market turmoil.

Lastly, time frames while screening for dividend growth and dividend policy discipline matter. Longer track records indicate strength through business cycles, while shorter ones might prove more dynamic. More importantly, we cannot ignore that dividend strategies are correlated to other equity market factors, and hence have important consequences on broader portfolio construction. For instance, high dividend yield would tend to have similar attributes to “value” factors, dividend growth could be expected to move in tandem with other “growth” factors while disciplined dividend policy could be considered a “quality” metric. In this context, dividend investing does make an implicit bet on the success of broader equity market factors and would be susceptible to both winning streaks and decay like most factor investing methods. An ideal approach for many investors would be a blend of the three approaches, with a fundamental overlay to qualitatively judge business prospects, continuity in dividend pay-outs and the scope for capital appreciation.

[2] Throughout this article, we either look at euro area equities on aggregate or the aggregate excluding financial companies, given the peculiarities of the financial sector in terms of financial statement analysis and its divergence from the overall market in the current economic cycle.

[3] Damodaran, A., “Assessing dividend policy: Or how much cash is too much”, NYU Stern School of Business.

[5] Although taxation is an important consideration for any investment decision, we avoid its implications here and look at gross returns given the specificities of taxation depending on domicile, status and regime.

[6] Miller, M. H., and Modigliani, F., “Dividend Policy, Growth and the Valuation of Shares”, Journal of Business, October 1961

[7] We systematically rank the MSCI EMU (European Monetary Union) constituents on a quarterly frequency from 2004 to end September 2019 on dividend yield and trailing three-year DPS growth at point in time historically. We create equally weighted stock baskets comprising the highest quartiles of dividend yield and dividend per share growth companies. For the disciplined dividend policy group, we screen for companies that have not cut annual DPS in the last decade and simulate an equally weighted basket.

[8] We assume an initial corpus of €100,000 and quarterly expenses of €1,000. Expenses are adjusted every quarter based on aggregate euro area inflation. Expenses are primarily funded by dividends and then capital withdrawals in case of shortfalls. To minimize cash flow mismatches, a cash buffer of three times the current quarter’s expenses is maintained; any surplus above this is assumed to be reinvestment in the same equity basket.

[9] The Sortino ratios are calculated by subtracting the risk-free rate from the appropriate total returns, and then dividing that amount by downside deviation (standard deviation of negative returns). We use the ICE BofA ML 1-3 Year AAA Euro Government Bond Index as a proxy for the risk-free asset.

This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.

It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date. All information in this document is established on data made public by official providers of economic and market statistics. AXA Investment Managers disclaims any and all liability relating to a decision based on or for reliance on this document. All exhibits included in this document, unless stated otherwise, are as of the publication date of this document. Furthermore, due to the subjective nature of these opinions and analysis, these data, projections, forecasts, anticipations, hypothesis, etc. are not necessary used or followed by AXA IM’s portfolio management teams or its affiliates, who may act based on their own opinions. Any reproduction of this information, in whole or in part is, unless otherwise authorised by AXA IM, prohibited.

Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

This document has been edited by AXA INVESTMENT MANAGERS SA, a company incorporated under the laws of France, having its registered office located at Tour Majunga, 6 place de la Pyramide, 92800 Puteaux, registered with the Nanterre Trade and Companies Register under number 393 051 826. In other jurisdictions, this document is issued by AXA Investment Managers SA’s affiliates in those countries.

In the UK, this document is intended exclusively for professional investors, as defined in Annex II to the Markets in Financial Instruments Directive 2014/65/EU (“MiFID”). Circulation must be restricted accordingly.